Chapter 29 Open economy macroeconomics

1. Chapter 29Open economy macroeconomics David Begg, Stanley Fischer and Rudiger Dornbusch, Economics, 6th Edition, McGraw-Hill, 2000 Power Point presentation by Peter Smith

2. Open economy macroeconomics • … is the study of economies in which international transactions play a significant role • international considerations are especially important for open economies like the UK, Germany or the Netherlands • Domestic macroeconomic policy in such countries cannot ignore the influence of the rest of the world • especially via the exchange rate.

3. DD shows the demand for pounds by Americans wanting to buy British goods/assets. Suppose 2 countries: UK & USA SS shows the supply of pounds by UK residents wishing to buy American goods/assets. SS SS1 e0 Exchange rate ($/£) Equilibrium exchange rate is e0 e1 If UK residents want more $ at each exchange rate, the supply of £ moves to SS1 DD Quantity of pounds New equilibrium at e1. The foreign exchange market - the international market in which one national currency can be exchanged for another. The price at which two currencies exchange is the exchange rate.

4. Alternative exchange rate regimes • In a fixed exchange rate regime • the national governments agree to maintain the convertibility of their currency at a fixed exchange rate. • In a flexible exchange rate regime • the exchange rate is allowed to attain its free market equilibrium level without any government intervention using exchange reserves.

5. If the demand for pounds is DD1 there is excess demand AC. A C E The Bank of England must supply AC £s in return for $, which are added to reserves. DD1 DD2 The reverse occurs if demand is at DD2. Intervention in the forex market Suppose the government is committed to maintaining the exchange rate at e1 ... SS $/£ e1 DD Quantity of £s When demand is DD, no intervention is needed ... there is a balance in transactions between the countries.

6. The balance of payments • … a systematic record of all transactions between residents of one country and the rest of the world • Current account • records international flows of goods, services, income and transfer payments • Capital account • records transactions involving fixed assets • Financial account • records transactions in financial assets

7. The UK balance of payments, 1980-1998 Source: Economic Trends Annual Supplement

8. Floating exchange rates and the balance of payments • If the exchange rate is free to move to its equilibrium, there is no need for intervention • any current account imbalance is exactly matched by an offsetting balance in capital/financial accounts • if there is intervention, it is recorded as part of the financial account.

9. International competitiveness • The competitiveness of UK goods in international markets depends upon: • the nominal exchange rate • relative inflation rates • Overall competitiveness is measured by the real exchange rate • which measures the relative price of goods from different countries when measured in a common currency

10. Relative prices and the nominal exchange rate, UK & USA Relative price (UK/USA) Exchange rate ($/£)

11. The real £/$ exchange rate The real exchange rate is the nominal rate multiplied by the ratio of domestic to foreign prices

12. Components of the balance of payments • The current account is influenced by: • competitiveness • domestic and foreign income • The capital & financial accounts are influenced by: • relative interest rates • which affect international capital flows. • Perfect capital mobility • occurs when there are no barriers to capital flows, and investors equate expected total returns on assets in different countries

13. Internal and external balance • Internal balance • a situation for a country when aggregate demand is at the full-employment level • External balance • a situation for a country when the current account of the balance of payments just balances • The combination of internal and external balance is the long-run equilibrium for the economy.

14. More saving, tighter fiscal & monetary policy Foreign boom, lower real exchange rate Less saving, easier fiscal & monetary policy Foreign slump, higher real exchange rate Shocks may move an economy away from internal and external balance: Surplus Slump Boom Deficit

15. Macroeconomic policy under fixed exchange rates • Under fixed exchange rates, there is a crucial link between external imbalance and domestic money supply. • When the government intervene to maintain the exchange rate, there is a direct effect on money supply. • Sterilization • an open market operation between domestic money and domestic bonds to neutralize the tendency of balance of payments surpluses and deficits to change domestic money supply.

16. Monetary policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices • An increase in nominal money supply • tends to reduce interest rates • leads to a capital outflow • reducing money supply as the government seeks to maintain the exchange rate • so monetary policy is powerless • the government cannot fix independent targets for both money supply and the exchange rate • domestic and foreign interest rates cannot diverge

17. Fiscal policy under fixed exchange ratesAssume: perfect capital mobility, sluggish prices • An increase in government expenditure; • in the short run • stimulates output • but also increases interest rates • which leads to a capital inflow • money supply expands to maintain the exchange rate • there is no crowding-out • as interest rates cannot rise • in the long run: • wages and prices adjust, affecting competitiveness • the economy returns to potential output.

18. Suppose the economy begins in equilibrium with the nominal exchange rate at e1. At time t, nominal money supply is halved... B e3 C e2 will be the new equilibrium exchange rate once the economy has adjusted e2 e1 A t To maintain equilibrium in the forex market, the exchange rate overshoots to e3 , adjusting along BC with wages & prices. Monetary policy under floating exchange rates e But prices are sluggish, so in the short run, real money supply falls and domestic interest rates rise Time

19. Monetary policy under floating exchange rates (2) • This analysis suggests that with floating exchange rates, • monetary policy is highly effective in the short run • but the effect is only transitional

20. Fiscal policyunder floating exchange rates • Following an increase in government expenditure ... • the crowding-out effect of higher interest rates is enhanced by appreciation of the exchange rate • which dampens export demand • so fiscal policy is less effective under floating exchange rates.